By Michael J. Carr, CMT
Blackjack players at a casino will spend a lot of time deciding how much to bet on each hand. At least the serious ones do. Often, they even have a system. Traders may be surprised to realize they might not be as well prepared as savvy card players. Position sizing, or determining how much to bet on each trade, is often overlooked by traders. Simple strategies are sometimes used without any thought. Traders may buy positions with an equal number of shares, for example 100 shares at a time, or they use an equal dollar amount for each buy order. Neither of these approaches considers potential risks and rewards.
Sitting at the blackjack table, players will count cards, keeping track of how many face cards remain in the deck. They vary the size of their bet based upon what they think the probability of drawing a winning card is, increasing the amount at risk when the odds are in their favor. Applied to the stock market, successful traders call this money management, and they will vary their trade size depending on the perceived risk. These exact same ideas on position sizing and money management can be applied to futures, options, or Forex trading.
Trading involves seeking returns while accepting risk. One way to reduce risk is to spread your bets around. Gamblers understand this. They don’t usually go into a casino and bet their entire bankroll on a single hand. They know the odds of winning on a single large bet aren’t in their favor, but by placing a lot of smaller bets, they believe their odds of winning for the day go up. What they’re really doing is accepting a small risk of loss with each bet, while hoping for a large gain on one of the many bets they place.
Like gamblers, traders need to be willing to accept small losses in pursuit of large gains, even if they don’t think about risk as much as many gamblers do. Position sizing is the equivalent of spreading your bets around, and all traders tend to hold multiple positions in their account. Formulas have been developed to determine the optimal positions size, but these formulas are complex and few traders would have the psychological makeup to follow them. Maximizing returns, according to basic position sizing formulas, requires the trader to maximize risk. This means the account will suffer large losses while waiting for the large gains, and no one is really comfortable losing over half their account value, even if the advanced mathematical models show they’ll make it up in the long run.
Academic studies show that with about twenty positions, most individual risks can be reduced, leaving only the stock market risk. Two things are overlooked in these studies. First is that the market risk is significant and in the past, would have wiped out more than 75% of your account value. These are real losses to traders, even if academics claim they are “non-diversifiable systemic risks.” Second is that small traders can’t take twenty positions because they don’t have enough trading capital. Small positions offer only small potential gains so concentrated positions are required for the success of a small trader.
Traders who do apply position sizing to their portfolios often follow rules of thumb, such as believing they should never risk more than 2% of their account size on any single trade. This is thought of as a money management rule, and the position size is then determined by doing the math to see how many shares you should be with a given stop loss. For example, with a $100,000 account, you could buy 2,000 shares of a $10 stock and face a potential loss of $2,000 with a 10% stop loss. That means the trader would have five positions in their account instead of the twenty that academic research finds to be best.
The 10% stop loss represents an initial step towards money management. Beginning traders usually spend a lot of time figuring out how to get in and out of a trade. Buy rules generally get the bulk of their attention, and sell rules are often frequently defined by how much money they are willing to lose on a trade. Stock traders often set an initial stop 8-10% below their entry price, and move it higher on winning trades. That is the extent of money management for many traders. By keeping a sell order about 10% below the current price, they think they have limited risk. However, some stocks can move 10% in a short period of time, and this would mean a trader gets stopped out during a normal move in the stock. That’s a simple money management strategy, but the problem with following a simple money management rule is that it doesn’t maximize gains.
This simple approach is also impractical for small accounts, which would be anything under $100,000. There is also no underlying logic as to why 2% is the magic level of loss that should be tolerated. The reasoning seems to be that you can endure a lot of 2% losses before you’re wiped out. But with a $10,000 account, that only allows for a $200 loss, which isn’t enough in the real world.
No trader will be right 100% of the time. Losses are inevitable, and need to be accepted. At first, traders shouldn’t expect to be right more than half the time. If we assume the trader is only correct four out of ten times, a very realistic scenario if you’re just starting, profits are still possible with correct position sizing and money management.
Successful traders need to let profits run and cut losses quickly. Before entering the position, traders need to compare the potential gains to the potential loss. There are many techniques to do this. Chart patterns are often used, especially in stocks or Forex, and systems are widely employed by futures traders. Potential gains need to be greater than the risk, when measured in dollars. Ideally, the trade should have a potential reward of at least $160 for each $100 risked.
If this condition is met, very small traders, even those with less than $10,000, can make money by holding as few as four positions at a time. With a 40% win rate, traders will see small but steady profits. Gains can be increased by adding to winners. This is an example of money management. Traders could add to positions when the gain is 50% of the profit target. This way, you’re letting winners run. The stop loss is strictly defined, based upon the measured risk rather than a strict percentage rule, so you’re already cutting losses quickly.
As your account size increases, you can increase the number of positions you hold at any one time. But, you don’t need too many positions. Warren Buffett has been quoted as saying that diversification is an excuse for laziness, and traders should always remember that. There is no need to over diversify. Few of us have lots of good ideas, and there is little need for more than a dozen positions for most traders. This is contrary to the commonly held beliefs of most investors, but most investors fail to beat the market so it’s not always a good idea to do what everyone else does. Different rules may apply to very large accounts of a million dollars or more, but the reality is that even these accounts can benefit most from maximizing the gains of winning trades with money management rules.
Money management is really the same as risk management, and controlling risk is widely recognized as a key to success in trading. Smart traders will base their trades on the risk-reward potential of the stock, or futures contract or Forex position. They’ll make more from winning trades than they lose on the trades that don’t work. And in the end, that’s all it takes to be a successful trader.